With Bonds, A Little Leverage Can Go A Long Way

By Michael Aneiro

For investors looking to supercharge lackluster bond portfolios and make them perform more like stocks, all while reducing a portfolio’s stock-related risk, try adding some leverage on the bond side. That’s the argument made by Bridgewater Associates’ Ray Dalio and other prominent hedge funds such as AQR Capital Management in a story by Michael Corkery in today’s Wall Street Journal:

Leverage relies on borrowing money or using derivatives to make large investments while putting up less cash. The tactic’s widespread use helped inflate the world-wide debt bubble that burst during the financial crisis, and it was blamed for ruinous losses at banks and securities firms.

But money managers such as Bridgewater Associates, the world’s largest hedge-fund firm, and a growing number of pension funds say this type of leverage is different. By using leverage through derivatives, such as bond futures, and by investing in commodities, some pension funds believe they can reduce their typically large exposure to the turbulent stock market and still earn solid returns….

Pension funds and other institutional investors typically take most of their risks in the stock market. Mr. Dalio says risk parity spreads the risk to a pension’s bonds and other holdings. “Ironically, by increasing your risk in the bonds you are going to lower your risk in your overall portfolio,” he said in an interview.

A core tenet of risk parity is that when stocks are falling, bond prices typically rise. By using leverage, bond returns can help make up for losses on stocks. Without leverage, bond returns in a typical pension portfolio of 60% stocks and 40% bonds wouldn’t be large enough to compensate for low stock returns.